A good place to be

The so-called lost decade has not shaken legendary investor Peter Lynch's belief that the stock market will continue to offer the best returns.

The dismal returns of the past ten years have made them known as the lost decade on the US stock market, raising the question whether investment in stocks has lost its luster. Who better to answer that question than the person considered one of the best mutual fund managers in US history, Peter Lynch?

Lynch, 66, the legendary manager of the Fidelity Magellan fund, took over the running of the fund in 1977, and from then until he left the post in 1990, he managed to beat the S&P 500 Index in 11 years out of 13. Under his management, the fund yielded an exceptional annual return of 29.2%, almost double the average for the index of 15.8%. The greatness of Lynch's achievement can be seen from the fact that even today, 20 years after he stopped managing the fund, his books "One Up on Wall Street," "Beating the Street," and "Learn to Earn," are still best sellers among investors.

Today, Lynch is a research consultant at Fidelity Investments. He devotes the rest of his time to philanthropy, through a fund that he manages that awards scholarships to children from low-income families who study in Catholic schools in Boston, where he lives.

In an exclusive interview with "Globes", Lynch gives his view of the recent crisis and its consequences for the markets, and has no hesitation is sounding optimistic about the next hundred years for the stock market.

We chose to start the interview with the obvious question did some substantial change take place in the economy and the markets because of which the past decade became the lost decade for stocks?

"The past decade is one decade out of a hundred years in which we have known the markets," Lynch says, "We started it at an extraordinary peak in the stock market as a result of the sharp rises in 1999, but in a sense the past decade was the lost decade on the stock market mainly because stocks were overvalued."

Should we forget what we knew about stocks? Are they no longer the best place to be?

"We had 11 recessions since World War 2, and this is the twelfth that we have experienced in the US and the biggest, without a doubt. But you have to remember that only 2-3 years ago, the market was at an all-time high. Now the question is how we will emerge from this recession, and whether we will return to the growth patterns at the rate we saw before it."

At this point, Lynch briefly expounds his stock market theory, and explains why he thinks stocks are the best investment.

"Company profits in the US have grown at 6-7% a year, basically since World War 2. If we add to that the dividend yield, which is 2% a year, that is approximately the average annual return on stocks," he explains.

Lynch avoids making explicit stock recommendations, but he does not stint with examples. "Look at companies like IBM, Procter & Gamble, Coca Cola, Pepsico, Walgreen, or Exxon Mobile. I estimate that they will make more money in ten years' time than they make today, so that their share prices will rise to reflect that growth," he argues, quickly adding the rider, "Not all of them will do that, but there is a close connection between the share's behavior and the profits that the company produces.

"Over the past 30 years, the profits of McDonald's have tripled and the stock market has risen threefold, and that's true of other stocks," Lynch continues. "However, there's also the other side. Xerox, for example, makes less money than it did 30 years ago, and its stock is worth less than it was worth 30 years ago. Polaroid was a very exciting company a few down years ago, and it ended in insolvency. We have seen similar things happen at Eastman Kodak and General Motors.

"In general, stock market companies have succeeded in growing their profitability, and that's the reason to buy shares," Lynch sums up. "When you buy shares in a company, if it manages to produce profits, you are a partner in those profits. On the other hand, if you buy an IBM bond, after 20 years, the company will repay you the money and say 'thank you very much.' It will pay you the interest, but it will not be loyal to you, and you certainly will not enjoy the fruits of its success. That's the big difference between bonds and stocks."

You need 3-4 good stocks

What's the right way to be exposed to the stock market today?

"The average person can get to know 5-10 companies very well, and once every few years he will come across an opportunity to make a good investment. In principle, you need 3-4 good companies to invest in over ten years. You don’t need 3-4 good stocks every week, if you are a private investor.

"You can't understand and be familiar with all of the market all of the time. You have to exploit your advantage to invest in what you really understand in depth, and not in what you don’t. If you gamble and buy oil stocks one year and retail stocks the next and electronics stocks the year after that, that's not investment. That's just a bet.

"Another possibility of course is to invest through a mutual fund or an index fund, in the belief that the profits of US companies will rise nicely over the next 5, 10, or fifteen years, and you let someone else make the decisions for you."

What about ETFs, that allow spreading of investment over indexes?

"I'm not a big expert on ETFs, but logic dictates that if the market falls over the next five years, the ETF will fall with it, no?"

Against that, there's the argument that less than 15% of investment managers beat the index, and the rest lag behind it.

"At Fidelity, we had countless funds that beat the indices over periods of tens of years. In the past ten years, the market has been difficult, but I believe that in the next ten years, active fund managers will produce a better return than index funds and ETFs."

As for other veteran investment managers in the US market, for Lynch too the latest crisis was the worst he had experienced in his years in the industry. Despite the severity of the crisis, Lynch believes that it was only an exceptional, random event, and that, in the long run, the markets will get back on track.

Asked to share his lessons from the crisis with us, Lynch pauses for a moment's thought, and responds, "I'll tell you the same thing I would have said 10 or 20 years ago as well. To predict the market's direction in any given year is a completely random act. You can't know what the markets will do in a period of six or twelve months.

"On the other hand, you do know that, over the past 40-50 years, company profits grew at good rates, and in my view they will continue that way in the coming years too. I estimate that corporate profits will double themselves every ten years. If you add to that the dividends that the companies distribute, you get an excellent return," adds Lynch. "You have to believe that, in general, companies in the US will continue to grow. Naturally, along the way some of them will disappear and some new ones will join.

"When you participate in company profits, the most important point is whether you believe that they will be higher in another ten or twenty years or not," Lynch insists. "If not, then perhaps it would be better for you not to be exposed to them, not in an ETF, not in an index fund, and not in a managed fund. When you look at the alternatives for investment, the choice for investors today is between a money market fund, that produces a zero return, Treasury bonds, that yield 3.8%, or some exposure to the stock market that, over time, yields double that on average."

After leaving Magellan 20 years ago, Lynch reduced the scope of his activity in the markets. In the two decades since then, great changes have taken place in the financial industry and in the markets, one of the most prominent being the technological developments that now enable investors all over the world to be exposed to a far larger amount of information, and in real time. Lynch himself sees no difference between 20 years ago and today in the way investors need to approach the markets.

"In the course of my work at Magellan, I bought small companies that grew over the years. This is a strategy that worked, and still works today," he says. "I bought companies whose performance was weak and that turned their businesses around. This method still works today. If you invest in companies whose assets are worth more than their market cap, you have found a great investment opportunity."

This information spreads faster today thanks to the Internet. Doesn't that affect the ability to act in the market?

"It mainly affects the average investor, who now has greater access to information that was once the province of professional investors. In the end, the work is the same work you have to find companies traded at below their real value, and that will grow in the coming years."

Can your achievement at Magellan be replicated in the current market environment?

"That's a slightly more difficult question, because to beat the market in eleven years out of thirteen is a tough assignment, but there are a few fund managers who have done it in the past and who are doing it today as well."

Following the changes that have occurred in the markets and the "lost decade", has it become necessary to adjust the criteria for choosing stocks for investment?

"The significance of the lost decade is very simple. Companies earn more than they did ten years ago, and they are traded at lower prices than they were then. There's an investment opportunity here. There are companies on the market with good balance sheets and wonderful reputations, that make better profits today than ten years ago, and will continue to grow. This is an extraordinary period for investment."

Are price earnings ratios and growth rates as relevant now as in the past?

"When you look at big companies, you see that their growth slows down eventually, because they're too big to grow at high rates over time. On the other hand, small and medium size companies, which are generally considered riskier, grow faster over time. Therefore, there are opportunities in every kind of company. But I achieved my success thanks to a focus on companies of a small and medium order of size. I try to buy big companies only when they are at a turning point, after their position has improved following a crisis. That's how it is in the vehicle industry, airlines, and other industries."

Is that what you look for today companies that were hard hit by the crisis and can change direction?

"Exactly. The vehicle industry is a battered industry following the crisis, but people still continue to drive cars. The only difference is that the cars are getting older, and in the end they will have to be replaced with new ones. Something similar can be seen in the housing market. And these are just two of the biggest industries in the US, that fell to a vey low level. It's hard to believe that they will soon get back to where they were before the crisis, but they will clearly strengthen to some extent."

How do you identify those companies that will succeed in making the turnaround and won't crash along the way

"That's what is called homework. You have to do your homework."

And what do you examine when you do that homework? The management that can turn things round?

"I look for industries that I believe will make the change, not managements that will lead the change. I've said in the past, that I prefer to be invested in companies that any idiot can manage, because in the end, that is what will happen. When I buy Toys "R" Us, I act on the assumption that the next decade will be very straightforward for the company, no matter who manages it. They have a simple formula, they have practically no competition, so the next decade will be easy for them.

"The second way of making money is to go for companies with poor performance now, but that have a strong balance sheet, and are likely to recover as their industry recovers. Then, all that's left is to wait for the situation to improve. That is what's called cyclic change."

No need to look for stocks every day

What turns an investor into a successful stock picker?

"It takes hard work and flexibility. If you look at ten stocks, it could be that you will find one stock at an attractive price and nine at fair prices. If you look at a hundred stocks, you'll find ten. So the more companies you examine, the more opportunities you'll find. The second characteristic is flexibility, and here is where Fidelity's advantage lies. It employs hundreds of analysts who examine companies from all over the world. We look at every industry, and don't rule anything out. We don’t say that this or that industry is the best and focus just on that, but survey the entire market."

Does that mean investors have to devote most of their time to the stock market?

"You can exploit the information that already exists in you to invest in 5-10 companies, and that's all that is necessary. You don't need to spend all day looking for stocks for investment. It's enough if you invest two to three hours a month researching companies that you know and understand well in order to succeed."

What advice would you give investors today?

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"The most important organ in the body as far as the stock market is concerned is the guts, not the head. Anyone can acquire the know-how for analyzing stocks. We've had many recessions on average once every eighteen months we have had a 10% fall on the stock market over the past 50 years, and once every five years we have had a fall of 20-30%, which is called a bear market. Usually, this goes along with bad news, with your neighbor who lost his job, and with the value of your house that falls. The news is bad, and so you get out of the market, and when you read in the newspaper that the situation has improved, you go back in.

"You buy when you see that things are fine, and sell when you see that they are bad. But that's not the way. You have to decide what position in shares you will be comfortable with, and to understand that even in a bear market, time is on your side. What the market will do for a period of a year ahead is random. If you need the money for your child for college or for a wedding in a year's time, it's important that you should know that the market will be random over that year. But if you're looking at an investment range of 10 or 20 years, company profits will be on your side, and stock prices will be higher.

"You have to understand what you're doing and recognize the fact that things can go wrong. Recessions happen, and right at the point that things seem gloomiest, people withdraw their money from the market, and just then the market start to climb. Look at the latest rally that we have had since March. The economy still isn't sufficiently stable. We have an unemployment rate higher than 10%, and the recovery in many areas of the economy is fragile, but we had an impressive rally nevertheless. The stock market looks to the future and not to the past. The tendency of people to run when the situation is bad and go in only when it's good is a good formula for losing money.

"You have to look in the mirror and ask yourself, 'What will I do if the stock market falls 10% over the coming year? Will I sell everything?' If your answer is positive, maybe it would be better for you to sell today. The stock exchange is a good place to be. In fact, it was the best place to be in the last 100 years, even if it wasn't like that in the past decade."

And what about the next 100 years?

"I think it will be a good place to be in the 10, 20, and even 100 years to come."